Pros and Cons of TIPS Mutual Funds

how do tips funds work

TIPS mutual funds offer many advantages to investors. TIPS are bonds issued by the US Treasury that pay a coupon on the adjusted principal of the bond. The bond is adjusted on a semi-annual basis with the rate of the Consumer Price Index (a measure of inflation). So, TIPS are said to keep pace with inflation by returning the adjusted principal upon maturity and coupon payments along the way.

The Pros of TIPS Funds

You can invest in Treasury Inflation-Protected Securities through mutual funds and enjoy many of the advantages that mutual funds offer such as:

  • Professional Management -- Fund managers will add value by looking for underpriced TIPS in the secondary market.
  • Diversification -- TIPS with varying maturities will be owned by a TIPS fund creating a more diversified portfolio.
  • Convenience -- Unlike buying a TIPS bond, a TIPS fund can be readily bought and sold in odd dollar amounts. Investors will not need to roll TIPS upon maturity, but can be assured the mutual funds will have constant exposure to TIPS.
  • Reinvestments -- As opposed to TIPS bonds, income from TIPS can be automatically reinvested in the fund without a sales charge.

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The Cons of TIPS Funds

  • Volatility -- As opposed to TIPS bonds, TIPS mutual funds do not have a maturity, so investors wanting to cash out must accept the current price (which may be higher or lower than the amount originally invested).
  • Fees -- There are fees associated with buying TIPS mutual funds that go

    beyond the transaction fee charged for TIPS bonds.

Tax Tips on TIPS Mutual Funds

Investors in TIPS mutual funds are taxed on both the annual income and the amount of the adjusted principal (i.e. the increase in the principal amount due to CPI) each year. The tax on the adjustment is referred to as “phantom income” because the investor doesn’t actually receive the adjustment in the form of an interest or dividend payment.

Many TIPS mutual funds will pay out the principal adjusted portion as a dividend, but if you reinvest the dividends, it’s a mute point. You are still not receiving the dividend, yet you will owe income tax on the dividend payment. For this reason, many investors wisely choose to hold TIPS in a tax-deferred retirement account (e.g. IRA) to avoid the taxation.

Final Tip on TIPS Mutual Funds

It may seem counterintuitive, but buying a TIPS mutual fund will not necessarily protect your principal. In the short-term, TIPS funds may be volatile. TIPS are priced on a daily basis based on expectations of future inflation rates (and the value is also affected by changes in interest rates). If you own the TIPS bonds outright, you are assured to receive your adjusted principal upon maturity. However, a TIPS mutual fund does not mature. There is not a guarantee that when you want to withdrawal your money, that you will receive the full amount of your investment .

Unless you are a speculator, buy TIPS mutual funds for long-term inflation protection for a portion of your fixed income portfolio.


Category: Taxes

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